Light on the horizon for quality British property

Indeed, it is difficult to recall a time when there was such consensus among investors around the need for a correction.

It is the relative asset pricing and cost of debt that is driving the fall in property capital values.

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The capital market started faltering in late spring in anticipation of a higher interest rate environment to curb surging inflation, resulting in relatively gentle falls in property values towards the end of July and August of about -3%.

But it was the Truss government’s cavalier Mini Budget that served to accelerate the downward trajectory in values.

The resultant spike in UK gilt yields to 4.5% from as low as 1% at the start of the year has naturally caused investors to question the fundamentals of property pricing.

With higher gilt yields, the case for property acting as a sort of bond proxy is no longer so compelling. A correction in property pricing – in other words, an expansion in property yields – is subsequently required to take the property risk premium back to a more attractive level.

Only then will new investment be justified.

However, it is not all doom and gloom for British real estate investors.

Rather, there is cause for some cautious optimism – particularly for highly selective property managers.

Rent remains resilient

With gilt yields falling back in recent weeks and stabilising just under 3.5%, there is some renewed confidence and activity.

Despite the capital value falls, rents are still growing across the property market.

While there have been very few deals completed since the Mini Budget, agents are reporting good interest in high quality assets from property companies, family offices, high net worth individuals, and international buyers – with sales attracting multiple bids and some deals being agreed.

Although valuations are still lagging, the levels of pricing likely to materialise as new deals complete, they are moving quickly towards market clearing levels – particularly for certain high quality assets and subsectors.

Industrial set to stabilise

Given to its strong fundamentals, better-than-average take-up and constrained supply, the industrial sector is repricing the quickest.

Due to the space’s low starting yield derived from extremely strong capital growth post-Covid, industrials are also seeing the deepest capital value falls.

We expect prices in this sector to stabilise most quickly as investors see opportunities to enter a sector offering continuing prospects for income growth.

After all, the take-up of distribution units over 100,000 square feet during 2022 is already ahead of the ten-year average.

In addition, this higher level of take-up since Covid has constrained supply, with vacancies now at record lows.

With high construction costs, new development will continue to be limited and therefore the prospects for continued rental growth for good quality assets remain robust.

Lack of quality offices on offer

Meanwhile, the outlook for offices will be tied closely to the fortune of the economy, and more specifically, the employment market.

Rising costs and a weaker economy may accelerate business decisions regarding space rationalisation, particularly in light of hybrid working arrangements becoming the norm.

However, the polarisation in performance between primary and secondary assets continues, so the story of offices is nuanced.

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There remains a severe shortage of modern buildings that offer best-in-class amenity and ESG credentials – particularly in the largest regional cities.

n fact, the take-up of grade-A space in the six largest regional markets remains healthy, generating record rental levels this year.

Holders of these types of assets should find resilient income returns and potential income growth due to the growing focus of corporate occupiers on staff retention and meeting carbon reduction targets.

As such, investors must be highly selective with regards to which office assets they seek to hold moving forward.

Additionally, investors can drive the performance of offices – and broader property assets – through active management strategies.

These include traditional initiatives such as physical extensions, refurbishments and lease renegotiations to improve value, as well as delivering positive ESG impact through enhancing the sustainability credentials of facilities or pursuing social value strategies that benefit the asset’s surrounding community.

Robust residential

As for residential, the underlying fundamentals driving rental growth remain strong – and this will not change in the short term.

Rising borrowing and living costs will drive higher rental demand, and even if housing values fall as forecast, first-time buyers still struggle to achieve home ownership until interest rates start to trend back down.

As such, the demand for rental accommodation continues to grow, while at the same time, the supply of rental product remains in decline.

Moreover, institutional private rented accommodation remains a very small proportion of the market and private landlords continue to exit, due to changing regulation and rising borrowing costs.

This is supportive of continued rental growth, while the weakness in the capital market presents an attractive buying opportunity.

Tim Munn is chief investment officer at Mayfair Capital